Financial and Economic Impact of the Global Financial Crisis of 2007-2009 on Pakistan

: Dr. Tayyeb Shabbir
Professor Shabbir is an Associate Professor of Finance, College of Business Administration and Public Policy at the California State University Dominguez Hill, Carson, CA. He has published over two dozen articles in scholarly journals and recently co-edited a book on Financial Crises with Nobel Laureate Lawrence R. Klein.

Introduction:

The Global Financial and Economic Crisis of 2007-2009 with its epicenter in the United States ultimately had its reverberations felt around the world though the degree as well as the exact mechanism of the spread of these illeffects has differed for different parts of the world. Pakistan certainly has not been immune to the contagion from this crisis – in fact; in this case, the global crisis impacted the country when it had been already struggling rather precariously with structural macroeconomic stresses that were unrelated to the global crisis. The goal of this paper is to analyze the various facets of the financial and economic impact of this global financial crisis on Pakistan. 1

“…crisis-induced reduction in
aggregate demand resulted in
significant reductions in global
trade volumes”

By virtue of it being the world’s sixth most populace country and the second largest economy of South Asia commanding unquestioned geo-political significance, analyzing the impact of this crisis on Pakistan is certainly of great importance.The above global financial crisis had its genesis in the so-called ‘Sub-prime’ crisis in the U.S. that started in earnest during late summer, 2007. Since the early 2000s, the United States had pursued ‘easy’ monetary policy that kept interest rates low. Combined with a lax regulatory regime in issue of credit especially for housing mortgages, this set the stage for a huge housing asset bubble. In addition to the U.S., there were similar ‘bubbles’ that had developed in European and other Advanced Economies. In the relevant literature, it is often hypothesized that the global imbalances (large current account surpluses and deficits across countries) of late 1990s and early 2000s had precipitated an environment of ‘cheap’ money where surplus funds were chasing yield and excessive risk taking had become the norm 2.

In this backdrop of evident excessive risk taking and high leverage which was certainly the case in the U.S. housing market, financial innovation known as securitization went awry and proved to be an immediate trigger for the financial crisis that ensued. This otherwise positive financial innovation of ‘securitization’ (Mortgage Backed Securities or MBS and Collateralized Debt Obligations or CDO) proved to be ‘faulty’ since it failed to work properly with the existing structure of financial institutions. In addition, ‘lending exuberance’ manifesting itself in lax underwriting standards at a time when real estate boom was waning in 2006, deficiencies in assessments of rating agencies (as well as ‘over reliance’ of investors on these assessments to the exclusion of other due diligence measures) and evident regulatory failures were the various factors that ultimately led to a serious yet uncertain degree of impairment of the values of MBS and CDO securities. This pervasive uncertainty created serious practical difficulties. The various financial institutions holding these securities were faced with illiquid markets and rapidly falling market values of their assets and, as a result, they started deleveraging to conserve capital 3. This resulted in a ‘credit squeeze’ with its severely negative repercussions on the real sectors of the Advance Economies where households and businesses pulled back from spending. This crisis-induced reduction in aggregate demand resulted in significant reductions in global trade volumes and, in particular, reductions in exports from the rest of the world to the Advanced Economies. This global trade effect then became the most important channel of transmission of the crisisinduced recession to the Developing Economies.

Besides the afore-mentioned behavioral mechanism related to the banking sector’s credit freeze and the consequent reduction in aggregate spending by the private sector, the other main channel of contagion was the ‘crisis of confidence’ unleashed by the breakdown of the securitization market and the very onset of the recession in the U.S. in December, 2007. By the end of 2008, the U.S. ‘Sub-prime’ crisis had become a full blown global financial and economic crisis.

The remainder of this paper analyzes the following issues in turn: (a) the state of Pakistan’s Economy on the eve of the outbreak of the global economic crisis (b) observed impact of this crisis on important macroeconomic variables for Pakistan (c) main channels of transmission of the effects of this crisis from its epicenter in the U.S. and Advanced Economies (d) the governmental policy responses to combat the effects of this crisis and (d) the medium to long run prognosis for the Pakistan economy in the wake of this global financial crisis.

State of the Pakistan Economy just prior to the advent of the Global Economic Crisis

Even prior to the advent of the global financial crisis, Pakistan’s economy was in a dire macroeconomic state. The macroeconomic mismanagement of several years since 2005-06 often characterized as the era of ‘twin’ deficits of current account (CA) and fiscal balance was only exacerbated immensely by the arrival of another ‘twin’ shock, this time external, in terms of the global fuel and food price surges of 2007 and early 2008. Buffeted by these pair of ‘evil twin’ phenomenon, to coin a term, Pakistan was certainly in very vulnerable situation when in late 2008 and early 2009, the full recessionary brunt of the global crisis impacted many a developing countries including Pakistan. As reflected in a simultaneous rise in fiscal as well as current account deficits, macroeconomic imbalances in Pakistan had been building up since FY 2004-05. A fiscal surplus of 3.7 percent of GDP in FY03 turned into a deficit of 2.3 percent of GDP in FY04, which was the start of an adverse trend of annual fiscal deficits. Again, a CA surplus of 4.9 percent of GDP of FY03 turned into a deficit in FY05 and joined the above negative trend. Amongst the multitude of factors for these ‘twin’ deficits are: country’s loss of competitiveness in a post-WTO regime for multi-fiber export markets, a growth strategy that was consumption

“The macroeconomic mismanagement
of several years since
2005-06 often characterized as
the era of ‘twin’ deficits of current
account (CA) and fiscal balance
was only exacerbated immensely
by the arrival of another ‘twin’
shock, this time external, in terms
of the global fuel and food price
surges of 2007 and early 2008.”

driven rather than export-driven and financed in large part via foreign savings, and a failure to rationalize the fuel import price increases that had just started to edge up in 2004-2005. As can be seen in Table 1, as a consequence of these factors, FY06 and FY07 were clearly years when both the fiscal as well as CA deficits were on the rise (a trend that, in fact, had started earlier in FY05).

t1

The macroeconomic imbalances for Pakistan were only made much worse by the unexpected global surges in fuel as well as food prices in 2007 and early 2008. This only exacerbated the ‘twin’ deficits syndrome and these deficits grew to almost twice the order of magnitudes in FY08 as compared to FY07. These fuel and food price ‘shocks’ are considered perhaps the most relevant factor that characterized the harmful impact of the 2007-09 global financial crisis on South Asia and thus they are worthy of a little more attention 4.

Fuel and Food ‘Twin’ Price Shocks: As can be seen from Figure 1, the world-market fuel prices that had been on an upward trend since early 2004 really took off in early 2007 and reached a peak in early 2008 (300% increase between January 2007 and January 2008) whereas the world food prices started rising in the middle of 2006 and peaked in early 2008 as well (175% increase between January 2006 and January 2008).

 This twin ‘shock’ in terms of a significant surge in food and fuel prices was bad news for many a developing countries that needed to import these commodities. This was certainly the case for Pakistan as well as for other South Asian countries. Besides having negative effects on the current account balances and accelerating inflation, these developments worsened the fiscal deficits too as the governments ended up subsidizing the domestic cost of these items in a bid to protect the consumers.

Financial and Economic Impact of the Global Financial Crisis of 2007-2009 on Pakistan1

Source: IMF and ODI, “Rising Food Prices: A global crisis”, Briefing Paper # 37

Pakistan has a significant dependence on imported oil (almost 50% of its energy needs) to meet the needs of its transportation sector and other modern sectors of its economy. During 2006-2008, Pakistan imported 0.28 to 0.33 million barrels of oil/day (Pakistan imports 80% of its crude oil) and, more broadly, during the same period, energy imports comprised almost 25% to 33% of Pakistan’s Total Merchandise Imports. The oil import bill almost tripled from 2004-05 to 2007-08 as it rose from $ 4.7 billion to $ 11.4 billion during this time period.

Given the extent of dependence on Energy imports, it should not be surprising that inflation rates for Pakistan (in fact for all South Asian countries) spiked in 2008. For Pakistan, it increased from 7.8% in 2007 to 12.0% in 2008 (on its way to 20.8% in 2009); for India, inflation rate increased from 4.7% in 2007 to 8.7% in 2008; for Bangladesh it increased from 7.2% in 2007 to 9.9% in 2008 and, finally, for Sri Lanka, inflation rate increased from 15.8% in 2007 to 22.6% in 2008. Energy import price spike was a major contributor to the above inflationary surge in all these South Asian countries 5.

Besides the oil price surge, inflationary spike in imported food was also problematic. As noted earlier with reference to Figure 1, world prices for the ‘Food’ category which includes cereals, pulses and edible oils increased sharply by 175% between January 2006 and January 2008. During 2006-07, Pakistan imported 9.5% of the ‘Food’ it consumed, which raised its ‘overall inflation rate’; in fact, ‘food inflation rate’ generally exceeded the ‘overall inflation rate’ (for instance, for 2007-08, ‘food inflation’ was 17.5% for Pakistan whereas its ‘overall inflation rate’ was 12%). Of course, this has meant a greater burden on the relatively poorer households who spend as much as one third to one half of their budget on food as compared to only 8% in Advance Economies like the United States.

Generally speaking, in addition to being inflationary, the net imports of fuel and food, translated into worsening Current Account as well as fiscal balance for Pakistan. The primary impact was on the Current Account since these imports were paid for in U.S. dollars. Due to this surge in import bill, Pakistan’s year over year International Reserves dropped by almost 5 percent. Again, the commodity price surges, especially in the case of oil, resulted in increases in fiscal budget deficits since the governments tried to subsidize the domestic price in order to protect the local consumer. Thus the commodity price shocks of 2007 and early 2008 considerably worsened the macroeconomic imbalances that Pakistan had been experiencing since 2005-06. This was no way to ‘meet’ the additional distress that the global financial crisis was about to visit on Pakistan (and of course much of the rest of the world).

Observed Impact on important macroeconomic variables for Pakistan due to the global financial crisis

Arriving on the heels of the terms-of-trade shocks resulting from the imported food and fuel price hikes, the global financial crisis had a significant impact on the Pakistan economy resulting in a serious deceleration of economic growth, worsening current account balances, widening fiscal deficits, accelerating inflation, dwindling International Reserves and domestic currency depreciations.

Real or Inflation-Adjusted GDP Growth Rates : In the ten to fifteen year period prior to the global crisis of 2007- 2009, the Pakistan economy along with that of South Asia region had enjoyed a moderately high real GDP growth rate. According to the World Bank, South Asia’s real GDP growth rate averaged 6.0% per annum for the period 1995-2005 which accelerated to 9.0% and 8.5% in 2006 and 2007 respectively, years immediately preceding the crisis. However, this rate decelerated to 5.7% in 2009 with there being a significant diversity in the experience of individual countries in the region.

In order to provide a regional perspective to Pakistan’s experience, let us note the changes in real GDP growth for a few of the South Asian countries. As is evident from Table 1, India and Bangladesh as well as Sri Lanka fared relatively well while Pakistan suffered the largest decline in the observed real GDP growth rate. As noted in the last column of Table 1, Pakistan’s real GDP declined by 4.9 percentage points in 2009 as compared to 2007, whereas, for the same time period, Bangladesh’s growth rate decline, which was relatively the smallest, amounted to only 0.5 percentage points 6.

Pakistan’s precarious outcome has been due to an unfortunate confluence of pre-crisis vulnerability due to terms-of-trade shock, political instability and geo-political trauma on account of terrorism related security concerns. As a result, Pakistan witnessed a sharp decline in economic growth from an average of 7.3 percent during 2004-07 to 4.1 percent in 2008 which further decelerated to 1.9 percent in 2009 as the security environment deteriorated even more.

Besides affecting real GDP growth rates, the crisis also adversely affected a myriad of other important macroeconomic indicators such as current account deficits and inflation rates. In order to present a more complete picture of the observed economic impact of this crisis episode, we now turn to data on these various macroeconomic indicators for Pakistan as presented in Table 2.

t2

Pakistan’s CA deficit which was already at a relatively high level of 4.8 percent of GDP in 2007 almost doubled in 2008 and was slow to recover. Closely related, Trade Balance deficit reflects a longer term trend (that goes as far back as 2004-05) of slow growth or declines in exports without concomitant declines in imports, thus widening Trade Balance deficits. Of course, it will be most desirable to have exports grow relatively fast so as to allow imports to keep growing as well without precipitating serious Trade Balance deficits.

The FY09 has across the board ‘bad’ numbers since this is when the full brunt of the global financial crisis impacted Pakistan. Thus Foreign Direct Investment (FDI) as a representative of Capital Inflows declined, as did Foreign Exchange Reserves (bottomed out in FY08). One ‘bright’ spot was worker’s remittances which stayed up and are expected to play the role of an increasingly important source of foreign capital inflows in the future. Of course, the especially disturbing development was the low grade hyper-inflation in FY09 (20.8%). Inflation rate soared not only due to monetization of ever-growing fiscal deficit by direct borrowing from the central bank but also because of the unusual global price surge in fuel and food prices during 2007 and early 2008. The fiscal deficits rose to 7.6 percent of GDP in FY08 from 4.4 percent of GDP in FY07 due primarily to government’s subsidy programs to prevent the full pass-through effect of rising import prices of fuel and food to reach domestic consumers. As a result, the month-on-month headline CPI inflation surged to 25.3 percent by August 2008 compared to 6.5 percent in August 2007.

As has been discussed later on, Pakistan is currently a part of an IMF Stabilization program which has entailed a relatively tight monetary policy as well as, initially at least, a tight fiscal policy in order to bring inflation down and stabilize the economy. Along with abatement of ‘supply shock’ of fuel and food prices, this is expected to moderate inflation. However, it seems that Pakistan may still have some ways to go in this regard

In addition to the above effects, domestic currencies depreciated in most of the South Asian countries on account of outflow of capital due to the global financial crisis. Most significantly, Pakistani rupee depreciated by almost 25% in 2009 as compared to Indian currency that depreciated by approximately 14% in 2008.

Transmission or Contagion of the Crisis to Pakistan

In the initial phases of the 2007-2009 financial and economic crisis, there was a significant amount of speculation that the adverse impact of this crisis will not spread beyond its place of origin in the U.S. and Europe on account of “decoupling” of the Asian and Emerging Economies in general. This hypothesis received some apparent support from the fact that these Emerging Economies seemed to continue to grow even in the face of the onset of crisis in Advanced Economies. However, given the severity of the shock and, equally importantly, the presence of a multitude of channels of transmission it proved to be only a matter of time for the contagion to take effect.

As is the case for all Emerging Economies, there are two main external channels that are capable of transmitting the impact of the global financial crisis to Pakistan – foreign financial flows and international trade. We will discuss the above transmission channels in turn.

(a) Financial Channel: The immediate impact of the crisis would certainly manifest itself in terms of a ‘crisis of confidence’ resulting in a ‘sudden stop’ or even a ‘reversal’ of capital inflows. This would imply an adverse impact on foreign capital inflows both in the equity as well as the debt markets.

Generally speaking, in the wake of the global financial crisis, international capital inflows to all countries of South Asia including Pakistan declined. For instance, according to the World Bank, for South Asia, these inflows in the form of equities dropped by 0.7 percentage point between 2007 and 2009 (as a share of GDP) while bank lending and bonds-related inflows (also as a share of GDP) dropped by 1.5 and 0.5 percentage points respectively between the same time period.

Clearly the above adverse effects operating through the financial channel would be proportional to the degree of global financial integration of a given Emerging Economy Ironically enough, being relatively less integrated in the world’s financial infrastructure which is a negative characteristic in the long run sense, in the short run, Pakistan like the other South Asian countries was spared the full brunt of the financial sector mayhem experienced by the Advance Economies. Nevertheless significant adverse effects both in the stock markets as well as the debt markets were experienced by Pakistan.

Equity Markets: The stock markets around the world declined dramatically as the investor confidence plunged in the wake of the global financial crisis. The Dow Jones Index for the U.S. declined by almost 50% over a seventeen month period from its peak on October 9, 2007 to its trough on March 9, 2009 which included historic declines on September 15, 2008 and the days that immediately followed the shocking bankruptcy of the Lehman Brothers. The reverberations of this ‘crisis of confidence’ in investor confidence were also felt keenly in South Asia in general and in Pakistan as well. From the relative peak value of January, 2008 to the trough in January, 2009, Pakistan’s stock market value as measured by MSCI (or Morgan Stanley Capital International) Index in U.S. dollars fell by 75%; in comparison, the corresponding decline in the MSCI Index for ‘All Emerging Markets’ was 52 % while India’s stock market experienced a 66% decline.

While India’s economy and capital market are more integrated relative to those of Pakistan and on that account alone, one may have expected India’s stock market to have actually declined more during the time period in question, however, Pakistan experienced political turmoil and stock market disruptions unrelated to the global financial crisis which resulted in Pakistan’s equity markets declining relatively further 7.

Debt financing via international capital markets: Financing via international capital markets comprises of gross bond issue, bank lending and new equity placement and this is an important measure of the extent to which the global market is tapped for financing investments. Practically speaking, this is a good measure of the utilization of international markets for debt financing .

Pakistan’s measure of these gross inflows declined from a high of 2.42 percent of GDP in 2006 to only 0.39 percent of GDP in 2008 reflecting a significantly reduced activity in the international debt market for the country.

Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI): Both Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI) are important sources of foreign capital for South Asian economies – the former perhaps is a more significant contributor to economic growth as it represents longer term commitment by foreign capital. FDI is not only a source of financial capital it is also a conduit for managerial and technological expertise.

In general, all the South Asian economies, experienced a significant drop in FDI in year 2009 as compared to year 2008 which was clearly due to the liquidity crunch and the economic slowdown experienced by the Advance Economies. Pakistan suffered a significant decline in late 2008 (from $1842 million of FPI in 2007 to $19.3 million in 2008) and an outright outflow in 2009 with FPI equal to – $ 510 million. Being relatively more volatile and ‘fickle’, FPI tends to react much more quickly to changes in investor confidence. These significant declines in FPI for the South Asian economies clearly reflected the ‘crisis of confidence’ that accompanied the global financial collapse.

b) International Trade Channel : After a period of strong growth since the beginning of the decade, international merchandise trade plunged about 20 percent in real terms (35% in U.S. dollar terms) from the pre-crisis peak to its trough in early 2009 (Figure 2). This very sharp decline in global trade was precipitated by a multitude of factors related to the crisis. These factors included (a) severe recession in the Advanced Economies that reduced aggregate spending in general including on imports, (b) extreme uncertainty about economic future as well as lack of credit financing that led to a postponement of purchases of durable goods by consumers and investment goods by businesses – both these categories figure prominently in international merchandise trade and (c) reduced availability of trade financing that also impinged on the volume of international trade.

Generally speaking, the severe and sudden collapse in the global merchandise trade was the most important channel that transmitted the adverse effects of the financial crisis of 2007-2009 unto the Emerging Countries many of which were heavily trade dependent especially in Asia. This mechanism was certainly also found to be at work in Pakistan and other countries in South Asia though with a caveat. By virtue of the fact that Pakistan and in fact South Asia as a region, exhibits above-average reliance on service exports as a proportion of its total exports, the adverse effects of the crisis-related collapse of global merchandise trade were mitigated somewhat as services tend to decline relatively less in demand with income reductions.

Even though Pakistan got some ‘protection’ due to having a higher proportion of its exports in Services, being fairly well-integrated into the world trade nexus, it suffered a significant negative impact via the trade channel. Let us illustrate the above observation with some relevant data.

: Figure 2 Global Merchandise Exports 2000-2009

G1

Data Source: Speech given by FED Chairman, Bernanke on October 19, 2009.

http://www.federalreserve.gov/newsevents/speech/bernanke20091019b.htm

According to an analysis by the Federal Reserve, the various countries experienced declines in real GDP in 2008 in proportion to their measure of ‘trade openness’ as measured by the sum of exports and imports as a proportion of the countries 2007 nominal GDP. The calculated measure of ‘trade openness’ for Pakistan (30.94%) is below sample mean of 82.00% for the sample of 23 Asian as well as non-Asian countries used in this study8. This is consistent with the earlier observation that Pakistan and, in fact, South Asia as a group suffered less compared to the other groups of East Asian and Emerging Countries that were relatively more “open” according to the above measure.

According to an analysis by the Federal Reserve, the various countries experienced declines in real GDP in 2008 in proportion to their measure of ‘trade openness’ as measured by the sum of exports and imports as a proportion of the countries 2007 nominal GDP. The calculated measure of ‘trade openness’ for Pakistan (30.94%) is below sample mean of 82.00% for the sample of 23 Asian as well as non-Asian countries used in this study8. This is consistent with the earlier observation that Pakistan and, in fact, South Asia as a group suffered less compared to the other groups of East Asian and Emerging Countries that were relatively more “open” according to the above measure.

Buffers against the adverse effects of the global financial crisis: In the wake of the Global Financial Crisis of 2007- 2009, while foreign private financial flows and trade flows were “bearers” of adverse effects for the South Asian countries, there were several other factors which acted as “buffers” to soften the impact of the crisis on these countries. In this regard, we will now discuss remittances and the abatement of global commodity inflation during the middle of 2008.

Worker’s Remittances: For most of the South Asian countries, remittances from expatriate nationals working primarily in the Middle East are a very important source of inflow of resources which are in “hard” currency. These resources not only provide foreign exchange at the national level, they are often a vital poverty alleviating ‘transfer’ at the household level.

Pakistan’s remittance flow has held up relatively well especially the approximately two-thirds of the remittances that originate in the Middle Eastern countries. About 20% comes in from expatriates in the United States. Though non-Middle Eastern countries will continue to be important sources for remittances for Pakistan, during this crisis, the Middle Eastern countries have been a relatively more resilient source since in the immediate aftermath of the global crisis these economies were relatively protected from the effects of the global recessionary upheaval on account of the accumulated oil-revenue based surpluses and relatively insular economies. Thus hiring and retention of migrant labor has continued (except in the case of Dubai because its earlier real estate market collapse).

In any event, though remittance inflows have held up well in the period immediately following the onset of the global crisis, the lagged impact of the global slowdown on the Gulf and Middle East economies may translate into a slowdown in the rate of growth of remittances inflows in South Asia — something that the policy-makers will need to keep in mind. In any event, generally speaking, a lot of hope is being pinned on remittances as an increasingly important prospective source of foreign capital inflows for countries like Pakistan.

Abatement during mid 2008 of World prices of Fuel and Food: The worldwide economic slowdown that ensued following the onset of the Global Financial Crisis of 2007-2009, had a second order “beneficial” effect since it significantly moderated the global commodity inflation that had started in early or mid 2007.

Based on the IMF data, during the middle of 2008, global Energy as well as Food prices dropped approximately 62.5% and 37% respectively from the corresponding peaks in mid-2008. (Figure 1)

This abatement of the earlier upsurge in global food and fuel prices that had started in 2007, provided a much needed relief to the South Asian countries including Pakistan which, as we have noted earlier in this paper, have a fairly significant dependence on imported fuel and, to a lesser degree, imported food. However, while this price moderation certainly provided a welcome relief, it can hardly be relied upon as a long run structural panacea especially since these commodity prices are expected to be increasingly volatile with an upward trend.

Pakistan’s Policy Responses

In general, the policy-makers in the South Asian countries responded to the crisis in a pro-active fashion by relying on expansionary fiscal and monetary policies. However, since in practice, the expansionary credit policy failed to lower the cost of funds, the de facto ‘weapon of choice’ was an expansionary fiscal policy with additional spending on infrastructure and development programs to act as stimulus to combat recessionary effects of the crisis. Monetary Policy’s goal, on the other hand, was generally more nuanced since besides providing aggregate demand support, it also had to contend with liquidity crunch GDP in FY09 compared to 7.6 percent in FY08, the current account deficit narrowed to 5.6 percent of GDP in FY09 from a record high 8.4 percent in FY08. It was planned for the country to engage in moderately expansionary fiscal policy in FY10 and FY11 by increasing development expenditure to 3.8 percent of GDP and to 4.7 percent of GDP respectively. However, the recent floods which have devastated a large part of the crop land and also necessitated huge relief effort will unfortunately handicap fiscal stimulus efforts and will make it very challenging to achieve accelerated economic growth in the near future.

Pakistan did not follow or rather could not afford to follow the traditional stimulatory polices in the face of the recessionary effects of the global crisis since it was beset by ‘twin deficits’ of fiscal policy and current account as well as relatively high inflation rate. As discussed earlier, this economic vulnerability was the result of a trend of consumption-driven (vs. exports-driven) growth, which worsened current account deficits as imports rose disproportionately. Inflation rate soared not only because of monetization of ever-growing fiscal deficit via direct borrowing from the central bank but also due to the unusual global price surge in fuel and food prices during 2007 and early 2008. The Balance of Payments situation had turned truly precarious — the import coverage ratio had fallen as low as 8.9 weeks by end-October 2008 and Moody lowered the sovereign rating of Pakistan to B3 from B2 — in fact, making it costlier for the country to borrow in the international capital market. Clearly, immediate stabilization and injection of capital was thus needed. In November, 2008, Pakistan sought and obtained a Stand By Agreement with IMF whereby, in return of immediate balance of payments support, Pakistan committed itself to following tight monetary and fiscal policies in late 2008 and early 2009 to restore macroeconomic stability.

Thus, at the eve of the recessionary impact due to the global financial crisis, Pakistan found itself in the somewhat paradoxical situation of employing tight monetary and fiscal policies. Of course, this was so because the need for stabilizing balance payments situation and avoiding hyper-inflation took precedence over responding to financial crisis induced economic slowdown.

The tight fiscal policy during FY09 was aimed squarely at stabilizing the macro imbalances of the previous fiscal year. The goal was to contain domestic demand for both domestic and imported goods (to moderate pressure on current account and exchange rate) as well as introduce structural reforms to increase revenue collection. A measure of fiscal consolidation was in fact achieved in FY09 by phasing out of subsidies, cuts in development expenditure and limiting government borrowing from the central bank. As a result, fiscal deficit dropped to 5.2 percent of GDP in FY09 compared to 7.6 percent in FY08, the current account deficit narrowed to 5.6 percent of GDP in FY09 from a record high 8.4 percent in FY08. It was planned for the country to engage in moderately expansionary fiscal policy in FY10 and FY11 by increasing development expenditure to 3.8 percent of GDP and to 4.7 percent of GDP respectively. However, the recent floods which have devastated a large part of the crop land and also necessitated huge relief effort will unfortunately handicap fiscal stimulus efforts and will make it very challenging to achieve accelerated economic growth in the near future.

In terms of its monetary policy, considering the upsurge in domestic inflation in FY08, the State Bank of Pakistan (SBP) had considerably tightened its policy by raising the discount rate by 250 basis points during FY08 and it stood at 15% by November 2008. This was in addition to an increase in reserve requirements in May 2008. However, by October, 2008, the domestic banking system faced a liquidity/confidence crisis which forced SBP to inject Rs. 270 billion as well as ease reserve requirements, though policy rates were not reduced, thus there was a continued signal of a tight monetary policy. Nevertheless, with the easing of inflation in the subsequent months (primarily due to moderation in global commodity prices) SBP continuously reduced policy rate by 100 bps in April 2009 and then again in August 2009 by another 100 bps. The IMF’s SBA allowed SBP to introduce some key structural reforms to improve monetary transmission.

Relative success in stabilization led to Moody marginally upgrading Pakistan’s sovereign rating in August 2009, making international capital markets more accessible. The global crisis had made it easier for Pakistan to survive its U.S dollar denominated variable rate external debt, however, the crisis having resulted in a depreciation of the U.S. dollar against major international currencies has resulted in significant translation losses in terms of Pakistan’s external debt.

Finally, while Pakistan suffered a significant negative effect of the global financial crisis through the Trade channel as country’s exports declined due to lower aggregate demand in Advanced Economies, the relative ‘saving’ grace was that due to only a marginal degree of integration in the global financial and capital markets, the financial channel was muted when it came to contagion due to the global crisis. Thus no significant policy measures such as structural regulatory reform initiatives were needed on that account and as a matter of fact, the banking sector had been strengthened by the relatively successful financial sector reforms of the previous few years.

Prognosis for the Medium Term

Though, as a region, South Asia is considered to have survived the Global Financial and Economic Crisis of 20072009 rather well and while in its latest update, the World Bank paints a rather cheery picture for the region as a whole, there are very significant intra-regional differences in prospects of recovery and post-crisis growth profile 9.

Pakistan may, in fact, be an exception to the rather upbeat assessment of post-crisis South Asia. While the region as a whole is expected to grow at 6.9 percent in 2010 and nearly at 8 percent in 2011 (making it the second-fastest growing region after East Asia & Pacific), Pakistan’s expected growth rate is only 3.0 percent in 2011 which follows an estimated 3.7 percent growth in 2010— this is sub-par prospects relative to the country’s long term historical growth rate. Though the IMF Stabilization Program that was initiated in November 2008 has helped stabilize inflation rate and some of the macroeconomic fundamentals, there is much progress that is still needed in this regard. One positive dimension is the relative resilience shown by the inflow of remittances through the crisis. However, the domestic political uncertainty as well as the geopolitical stresses of dealing with terrorism continues to be major impediments. Further the devastating floods of summer of 2010 have destroyed vast amounts of cropland, infrastructure, and homes and adversely affected 20 million people making it an extremely challenging situation that may be further drag on a fragile economy.

Finally, with the ascendancy of East Asia and Pacific region, South Asian countries are being urged by the multilateral organizations such as the World Bank and the IMF to integrate themselves more and more into the rising East Asia to benefit from the ‘New Normal’—the brave new post-crisis fast-growing world. However, it is not clear that Pakistan, unlike some other South Asian countries, is convincingly positioned to take advantage of this new trend. The country may be too distracted by security concerns elsewhere and perhaps even not sufficiently integrated in the South Asian regional mechanism that may dovetail naturally with the supply chain and economic infrastructure of East Asia.

Concluding Remarks

The global financial crisis of 2007-2009 has been a significant ‘shock’ to the economies around the world. It precipitated the ‘Great Recession’ in the U.S. with its reverberations felt globally, underscoring the interdependence that continues to bind countries of the world. Pakistan, like the rest of the South Asia region, was impacted by the recessionary repercussions of this crisis at a time when it was already reeling from the fuel and food price ‘shocks’ of 2007 and early 2008. The global crisis found its way to the Pakistan economy mainly through the ‘trade channel’ as exports from the country became depressed. There were also significant capital outflows as well as capital market and banking sector distresses though, due to only a partial integration with the world’s banking and capital markets, the ‘financial channel’ of contagion was somewhat muted. The adverse impact of the global financial of crisis of 2007-2009 on the Pakistan economy was a significant one and it manifested itself in the form of decelerating economic growth, worsening already skewed current account and fiscal deficits, accelerating inflation and precipitating social distress especially for the relatively most vulnerable parts of the populace.

While overall South Asian region is starting to recover quite smartly, the recovery is not uniform across countries or macroeconomic indicators. India is recovering the fastest with perhaps the best prospects of returning quickly to its long term potential. Pakistan, beset by structural economic vulnerabilities as well as the need to deal with security and geo-political distress and natural disasters such as the recent floods, is expected to enjoy only a modest recovery at best. Again, while GDP growth has started to recover across the board for South Asian countries, other macroeconomic indicators such as the inflation rate and fiscal deficits bear watching. Finally, the economic recovery from the global crisis masks the ill-effects on the most vulnerable parts of the populace and, going forward, appropriate measures will be needed to address these concerns. One major prospective source of vulnerability is a possible repeat of the global food and fuel price surge of the kind we experienced in 2007 and early 2008.

Presently Pakistan is expected to grow at a rate of 3-4 percent, which is below its historical trend real GDP growth rate. While the challenges facing the country are surely daunting, judging from its historical economic performance, the country can certainly return to its potential trend path in a sustainable fashion given the right circumstances.

End Notes

1 For an analysis of the impact on South Asia, see Tayyeb Shabbir, “Global Financial Crisis of2007-2009: Economic and Financial Impact on South Asia,” Working Paper, California State University, June, 2010. The present paper relies in part on this earlier work by the same author.
2 There are two schools of thoughts regarding the nature of the causal link between the global imbalances and the global financial crisis of 2007-2009. One rather plausible characterization of this link is provided by Maurice Obstfeld and Kenneth Rogoff, “Global Imbalances and the Financial Crisis: Products of Common Causes,” paper presented at the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Santa Barbara, CA, October 18-20, 2009.
3 For a representative model of how financial institutions were forced into deleveraging, see Tayyeb Shabbir, “Anatomy of America’s Subprime Mortgage Crisis of 2007-08: Channels of Contagion”, in Conference Proceedings of the Global Academy of Business and Economic Research, Houston, March, 2008.
4 See Bruno Carrasco et al., “The Impact of the Global Crisis on South Asia,” ADB Working Paper Series No. 1, Asian Development Bank, February, 2010.
5 See Tayyeb Shabbir (2010), op. cit., for much of the supporting data for this paper that is not already noted here explicitly.
6 A study by Rashid Amjad and Musleh ud Din, “Economic and Social Impact of Global Financial Crisis: Implications for Macroeconomic and Development Policies,” Final Report, Pakistan Institute of Development Economics, Islamabad, Pakistan, July, 2010, uses Keynesian multiplier to quantify the impact on South Asian countries. Their analysis projects Bangladesh would be least affected by the crisis and Sri Lanka the most.
7 For an accounting of the political as well institutional trading related factors that caused a stock market crash in Pakistan during July, 2008 see http://www.time.com/time/world/article/0,8599,1824461,00.html
8 Ben Bernanke, “Asian and the Global Financial Crisis”, Speech given October, 2009. http://www.federalreserve.gov/newsevents/speech/bernanke20091019a.htm
9 World Bank, “Moving Up, Looking East”, World Bank South Asia Economic Update 2010